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A Pareto Criterion on Systemic Risk

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  • Wang, Weijia

Abstract

Perfect risk sharing is not an optimal design for financial system because it can increase systemic risk by facilitating risk contagion among financial institutions. However, risk sharing dominates betting according to most Pareto efficiency criteria. One reason for this might be that those Pareto criteria consider individual risk rather than systemic risk and neglect that betting may reduce systemic risk by segmenting the financial system and preventing financial contagion. Refining Pareto criterion to cover systemic risk, I pro- pose the systemic Pareto criterion which has two features: 1) satisfying facts that betting dominates risk sharing when systemic risk is considered. 2) be- ing applicable to scenarios with constant endowment to which current criteria cannot provide compelling suggestions. One implication from this paper is that betting can act as the stabilizer of the economy and prohibiting betting is not always helpful for financial stability.

Suggested Citation

  • Wang, Weijia, 2019. "A Pareto Criterion on Systemic Risk," MPRA Paper 93699, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:93699
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    More about this item

    Keywords

    Risk Sharing; Heterogenous Beliefs; Pareto Efficiency; Systemic Risk;
    All these keywords.

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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